Taking The Financial Road Less Traveled

Menu

Tag Archives: Wall Street

Ah, but I was so much older then, I’m younger than that now. -Bob Dylan, “My Back Pages”

10 years ago today I started this blog, originally titling it after Dylan’s famous song. At the time I saw it as an opportunity to try to warn people about the brewing bubble in real estate. I was early but nobody really wanted to listen anyway. They were just having too much fun. That’s one major lesson I’ve learned since then: people only change – their ideas, perceptions, attitudes and behaviors – once THEY decide to do so. The most persuasive and logical argument in the world is no match for a man on a mental mission.

The blog eventually evolved into a way for me to explore things I was learning and observing. Writing is a great way, maybe the best way, to do this. There’s just something about getting the ideas out of your head and putting them into words. You’re forced to really examine and refine them in the process. This process has been very valuable to me over the past decade just as an intellectual exercise.

Finally, the blog has now attracted a community of folks searching for the same thing: truth. (I know it sounds corny but it’s true. And, ironically, this was part of the motto of my old firm). I’m only interested in zeitgeist from a contrarian perspective. I’m far more interested in what really matters, what’s really going on and what to do about it. Through the blog I’ve come across a variety of likeminded individuals that have exponentially enhanced this thing as an intellectual exercise.

So, to all of you who have been reading, sharing and contributing, thank you. I’m grateful.

Let me begin this post by saying that the three sources I quote here are among the handful of voices on social media and the financial blogosphere I respect most. This is also why I’m especially concerned about this new trend.

What worries me is that I’m now hearing the “four most dangerous words in investing” from some of the smartest guys in the game. Each of the arguments I’m going to look at represent some version of “it’s different this time” in relation to overall stock market valuation.

I’ve made the case for months now that stocks are extremely overvalued. In fact, I believe there is a very good case to be made that while we may not have another full-fledged tech bubble on our hands, the broader stock market is just as overvalued today as it was fifteen years ago, at the peak of the internet bubble.

To counter or to justify this idea, some very smart people have gotten very creative. First, Alpha Architect recently ran a post on valuations determining that, “the stock market isn’t extremely overvalued.” It’s “normalish.”

However, and they do acknowledge this in the post, they are looking at today’s valuations in relation to the history of just the past 25 years. The problem with this is that the past 25 years represent the highest valuations in the history of the stock market so, obviously, today’s valuations will look much more reasonable when framed in that light.

In acknowledging the limitation of using just the past 25 years, however, the author of the post questions whether, “market conditions 100+ years ago may be different than they are today.” In other words, ‘it’s different this time’ so those historical measures are no longer be relevant. To their credit, they recognize, “this sounds a bit like the ‘new valuation paradigm’ thinking that prevailed during the dotcom boom when valuations went crazy.” Still, they are putting it out there for less circumspect investors to rely upon.

Similarly, my friend Jesse Livermore of Philosophical Economics recently posited in a terrific piece that there are very good reasons justifying the persistent high valuations of the past 25 years.

Should the market be expensive? “Should” is not an appropriate word to use in markets. What matters is that there are secular, sustainable forces behind the market’s expensiveness–to name a few: low real interest rates, a lack of alternative investment opportunities (TINA), aggressive policymaker support, and improved market efficiency yielding a reduced equity risk premium (difference between equity returns and fixed income returns). Unlike in prior eras of history, the secret of “stocks for the long run” is now well known–thoroughly studied by academics all over the world, and seared into the brain of every investor that sets foot on Wall Street. For this reason, absent extreme levels of cyclically-induced fear, investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go–as they did, for example, in the 1940s and 1950s, when they had limited history and limited studied knowledge on which to rely.

My problem with this line of thought is that it assumes that human beings have essentially begun to outgrow the behavioral biases that have ruled them throughout a history that encompasses much longer than just the past century. We have seen “low real interest rates” and “aggressive policymaker support” in the past. See Ray Dalio’s excellent letter on 1937 as an analog for today’s economy and markets. So this argument really hinges upon, “the secret of ‘stocks for the long run’ is now… seared into the brain of every investor…. For this reason… investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go.”

In other words, we have entered a new era where human beings have fully embraced “stocks for the long run” for the long run and without reservation so cycles will be muted and valuations remain elevated for the foreseeable future. Never mind the fact that the recent history of the financial crisis may contradict this idea. I think the burden of proof for this argument lies squarely with its author. I have my doubts. In fact, this sounds strangely similar to Irving Fisher’s famous line just days before the 1929 crash, “stock prices have reached what looks like a permanently high plateau.”

Finally, Alex Gurevich wrote a fascinating think piece over the weekend on the Fed, the economy and how they relate to stocks and bonds. While I truly appreciate following Alex’s thought process (as I do both of the previous authors’), it’s his case for owning stocks that strikes me as a clear rationalization of extreme valuations:

Singularitarians (such as Ray Kurzweil) believe that we are on the brink of explosive self-acceleration led by computers designing better computers, which design better computers even faster, and rapidly surpassing every aspect of human intelligence. Singularitarian philosophy is migrating out of the province of science fiction writers into the mainstream, and can no longer be ignored by long horizon investors… The idea of economic singularity allows me have a clear and consistent theory of unfolding events. I can be positive on stock market without being scared of valuations.

I don’t dispute the awesome idea of singularity. It seems inevitable and inevitably beneficial for society (though some very smart people would disagree). What I dispute is the idea that singularity should justify high valuations.

As I tweeted this morning, it reminds my of Warren Buffett and Charlie Munger on the awesome innovation of air conditioning and air travel. These things were miracle innovations that dramatically improved the lives of human beings but did they justify abandoning tried and true investment methods developed over long periods of history? In retrospect, the answer is obvious. Amazing innovation is truly inspiring but it shouldn’t inspire you to overpay for a simple stream of future cash flows that have been very easy to value accurately over very long periods of time.

Ultimately, only time will tell if it is, in fact, “different this time” or if history will rhyme once again and today will only represent another stanza in the poem it’s been writing for centuries. With all due respect to these three very wise market philosophers, my money is on the latter.

On the surface, this should give investors great comfort. Stock buybacks may be the most effective way for companies lacking growth opportunities to enhance shareholder value. Look a little deeper, however, and this fact should give investors pause. Why? Because companies may be the worst market timers there are. They routinely set buyback records at major market peaks and buy only a tiny fraction of that amount at major bottoms.Chart via Factset

How can that be? Shouldn’t the companies be in the best position to most accurately estimate their own intrinsic value and future prospects and thus most effectively buy low and sell high? Yes BUT companies are far more capable of buying back stock when cash is plentiful – when money is easy to borrow and profits are high.

The time when money is easy to borrow and profits are high, however, usually coincides with high equity prices. When money is hard to borrow and profits squeezed like during a recession, stock prices are usually much lower but companies are not in a position to take advantage. Buybacks, then, are very highly correlated with corporate profits and bond market risk appetites.

Right now companies are spending fully 95% of their profits on buybacks and dividends. As I recently wrote, profit margins peaked over a year ago. And aggregate corporate profits are expected to decline over the next two quarters for the first time since the great recession. It’s hard to imagine companies being able to maintain near-record buyback levels amid this pressure in profits.

But they can still borrow money to buyback shares, right? Well, borrowing power is also tied to profits and investors’ willingness to buy their debt. I have also written recently that bond market risk appetites peaked last summer and have diverged from equities ever since. Should this trend continue, it would not be supportive of continued buybacks.

All in all then, just like margin traders, households and the largest pension funds on the planet, the greatest source of demand for equities right now may also be maxed out.

Fifteen years ago to the day, the internet bubble peaked at Nasdaq 5,000. That same week, I quit as head trader and co-founder of what was to become a multibillion-dollar hedge fund firm, easily the costliest decision of my life.

I didn’t quit because I was unwilling to work 60-80 hours a week anymore. I didn’t quit because I didn’t like my partner, though that was true. I didn’t quit because I didn’t love what I was doing – I did!

I quit because I came to the conclusion – after it punched me square in the jaw – that the stock market, Wall Street and especially the firm I was working for, were full of shit and I just couldn’t be a part of it anymore.

For those who weren’t trading during the late 90’s it’s just not possible to fully explain the euphoria that characterized the “internet bubble.” It was a true mania. At the time, I had a prospective hedge fund client who was day-trading his own money honestly ask me, “if you can’t double my money every year why would I ever give it to you to manage?” and he said this with a straight face. Just like this guy, many people sincerely believed that 100% return per year was not only a reasonable expectation but a minimum hurdle.

What made things especially challenging for us at the time was that we had a value discipline. Our methodology involved analyzing insider buying and selling but also had a foundation in Ben Graham-style value. This was in our funds’ literature and it was clearly used to sell them. In the late 90’s, value suffered, especially as the Nasdaq went parabolic into its peak, as investors had eyes only for high-flying tech stocks.

Ball Corp was one of our biggest positions. That simple jar and can company would eventually become one of our biggest winners but was dead money back then, like most “old economy” stocks. We shorted Enron and WorldCom before they blew up. The cash flow statements there didn’t lie but it was the massive insider selling by the top execs that sealed the deal for us. During the market blowoff, though, short selling became a losers’ game.

So one day, out of the blue, my partner tells me to buy one of the poster child bubble stocks for our flagship fund. As the junior portfolio manager I wasn’t out of line asking what sort of insider activity peaked his interest because there sure as hell wasn’t any value to be found there. In a roundabout way, he said he essentially liked the momentum in the name. I tried to argue that this didn’t fit our methodology or our mandate but he had none of it. ‘Just buy it.’

This was sometime during late 1999 and other names like this one started coming across my desk. I argued each time that they just didn’t fit out mandate but my partner was hell bent on turning us into a momentum shop. If I remember correctly this was right around the time Julian Robertson threw in the towel. He had simply had enough of trying to keep up with the mania without giving up his principles. My partner, in contrast, decided to give up his principles. ‘If you can’t beat ’em, join em.’ Ultimately, I decided that I couldn’t put aside my own values, by abandoning a true investment discipline.

But that was only half of it. I came to discover that abandoning our mandate was the least of my ethical concerns. And when I addressed these other concerns with my partner, he told me he intended to push the boundaries of what was legal let alone ethical. The greatest irony of all was that he had come up with our firm’s motto: “truth and disclosure.”

To my mind, everyone around me had gone crazy. The stock market had morphed into a strange sort of Pleasure Island from the Disney movie Pinocchio. Speculators were insanely euphoric and it felt like only I could see the gates closing behind them as they started turning into donkeys, my partner leading the way. I quit almost immediately and without giving any notice.

That was fifteen years ago but it is burned into my memory like it was yesterday. Ever since I’ve spent my career trying to figure out how to best help people with their investments in the most ethical way possible. In part, this is why I’ve been writing this blog for almost a decade now. I also write here, to some degree, to clear my own conscience for being involved with an industry I’m ashamed of because the industry is a magnet for people like my former partner. It also sanctions and encourages the sort of manic behavior we saw back then and you deserve better.

STOP! Before you flood my inbox telling me I’m an idiot to put any faith in such a stupid concept, know that this is just for fun. This is not anything to be relied on for any reason, unless you’re just curious about these things, as I am.

Now that I’ve gotten that out of the way, I find it fascinating that at this point in the business cycle we are once again witnessing a race to build a record-breaking skyscraper. The “Skyscraper Index” is a concept that suggests, “the world’s tallest buildings have risen on the eve of economic downturns.” Statistically speaking it may not be entirely accurate but I find the theme to be very intriguing nonetheless.

Although the index was only created in 1999, this concept dates back to time immemorial. In fact, the tower of babel should probably be the first instance catalogued by the index. In short, humans built a tower to the sky to celebrate their god-like powers (of uniting humanity under one language) and were soundly smote in response. This story can be found in many religions, actually. And ever since there have been many great monuments built during times of economic euphoria as a testament to our greatness. Only shortly thereafter do we realize it was not so much greatness as hubris.

Construction of record-breakers like the Singer Building and the MetLife Building coincided with the panic of 1907. The Empire State Building, the Chrysler Building and 40 Wall Street, were all built or launched just prior to the 1929 stock market crash and subsequent Great Depression. The World Trade Center and the Sears Tower opened just prior to the 1973-74 bear market. Today, we have two New York developers racing to build the tallest residential building in the Northern Hemisphere.

So where are we in the business cycle? I have no idea. Over the course of modern history, however, our economy has suffered a recession every five years or so. The last recession ended June of 2009, just over five years ago. (In and of itself, this does not suggest we are necessarily due for a recession but global growth is clearly slowing and I doubt the US will be entirely immune.) The longest expansions in American history lasted about ten years. It may be fair to say, then, that we are probably closer to the end than the beginning of this particular expansion. And regular readers should know where I believe we are in the financial market cycle.

Late in the economic cycle, then, in the financial capitol of the world, which has benefitted mightily from the greatest money-printing experiment in the history of the world, we have two real estate developers in a heated battle to build a greater testament to their own greatness than the next guy. To my mind, it is the height of financial hubris and a clear example of economic euphoria. And it’s all happening just as luxury apartment sales in New York are starting to slow. All in all, I wouldn’t be surprised to see this index correlate with yet another economic and financial market peak.